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Unit 3

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25 views68 pages

Unit 3

Uploaded by

Laxmi Karki
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter : 3

ELASTICITY OF
DEMAND AND SUPPLY
In this chapter
 Concept and types of Price, income and cross
elasticity of demand, Measurement of Price, income &
cross elasticity of demand: Total outlay, point & arc
method, Used of price, income and cross elasticity,
Concept of elasticity of supply, Measurement of
elasticity of supply (numerical exercises
Elasticity of demand
Introduction
• First Announce by: Cournot and J.S. Mill and developed
by Marshall- "Principal of economics"
• The word elasticity means flexibility.
• Elasticity of demand is the measure of reaction of quantity
demanded to the change in its` determinants.
• A measure of responsiveness of quantity demanded to
the change in its determinants is known as Elasticity of
demand.
• "The elasticity of demand in a market is great or small
according as the amount demanded increase much or
little for a given a fall in price and diminishes much or little
for a given rise in price." -Marshall
Types of Elasticity of Demand
• There are as many elasticity of demand as its
determinants. There are mainly three types of elasticity of
demand as pointed.
• Price Elasticity of Demand
• Income Elasticity of Demand
• Cross Elasticity of Demand
Price Elasticity of Demand
• Price elasticity of demand is the measure of
responsiveness of quantity demanded to the change in
its` Price.
• Price elasticity of demand is the define as the ratio of
percentage change in quantity demanded to the
percentage change in its` Price.
It can be expressed as:
Cont…………….
• Symbolically,

Where,
Ep=Price elasticity of demand
Q= Initial Quantity demanded
 Q= Change in quantity demand
P= Initial Price
 P= Change in Price
Types(Degrees) of Price Elasticity of Demand

• There are five types of Price elasticity of demand.


As pointed:
• Perfectly Elastic Demand (Ep=∞)
• Perfectly Inelastic Demand (Ep=0)
• Unitary Elastic Demand (Ep=1)
• Relatively elastic demand (Ep>1)
• Relatively Inelastic demand (Ep<1)
Perfectly Elastic Demand (Ep=∞)

• The elasticity of demand is said to be perfectly


elastic if small change in price of commodity
leads to infinite change in the quantity demand.
i.e.

• Perfectly elastic demand curve is horizontal


straight and parallel to quantity(X-axis) axis.

Ep=
D
Perfectly Inelastic Demand (Ep=0)

• The elasticity of demand is said to be perfectly


inelastic if the quantity demand for a commodity
does not change with respect to change in its
price. i.e.

• Perfectly inelastic demand curve is vertical


straight and parallel to Price(Y-axis) axis.
Unitary Elastic Demand (Ep=1)

• When the proportion change in the quantity


demanded for a commodity is equal to the
proportion change in its price, the demand for a
commodity is said to be unitary elastic demand.
i.e.
Relatively Elastic Demand (Ep=1)

• When the proportion change in the quantity


demanded for a commodity is more than the
proportion change in its price, the demand for a
commodity is said to be relatively elastic demand.
i.e.
Relatively Inelastic Demand (Ep<1)

• When the proportion change in the quantity


demanded for a commodity is less than the
proportion change in its price, the demand for a
commodity is said to be relatively Inelastic
demand.
i.e.
Method of measuring Price Elasticity of Demand

• There are basically four method to measuring


price elasticity of demand.
• Percentage Method
• Total Expenditure(Outlay) Method
• Point method
• Arc method
Percentage Method
• Develop by Prof Flux
• It is improved method then outlay method
• It is measure as the coefficient of demand function
• In this method, Ep is measure the percentage
change in the quantity demanded of a commodity
with respect to percentage change in its price.

• Symbolically,

Where,
Ep=Price elasticity of demand Q= Initial Quantity
demanded
 Q= Change in quantity demand P= Initial Price P= Change
in Price
Total Expenditure(Outlay) Method
• Develop by Marshall
• Compare total expenditure in different prices
• It does not gives value of Ep
• It can be known whether the demand for
commodity is elastic, unitary or inelastic.
• Total outlay= Price x Quantity demanded
• If Ep>1 it means total expenditure increase with
fall in price and decrease with rise in price
• If Ep<1 it means total expenditure decrease
with fall in price and increase with rise in price
• If Ep=1 it means total expenditure remain
constant with fall in price or rise in price
Point Method
• Develop by Marshall
• It measures price elasticity of demand at a point
of demand curve
• It measures the proportion change in quantity
demanded in respect to a very small proportion
change in price.

• Price elasticity of demand at a point can be


calculated by
Point Method
• Derivation of formula….
Arc Method
• If we calculate price elasticity as coefficient of
demand between two points on a demand curve
is called arc method. This method is used when
there are large change in price and quantity
demanded.
• The formula for measuring price elasticity of
demand at the middle point of the arc on the
demand curve is written as:
Arc Method

Where, Q1=Initial quantity demanded


Q2= New quantity demanded
P1=Initial Price
P2= New Price
 Q= Change in quantity demand
P= Change in Price
Numerical examples
I. Suppose, Price of a commodity rises from Rs 8 to Rs
10, it quantity demanded falls from 400 units to 300
units. Find out nature of elasticity of demand by total
expenditure method.
II. Calculate the price elasticity of demand using point
method and interpret your result at price is 200 for the
following demand function.
Qx=600-2px
III. Calculate the price elasticity of demand by using
percentage and arc method, when price decrease from
Rs 20 to Rs 10 in the following table:
Price 20 10
Quantity Demanded 40 80
Use of Price Elasticity of demand
We can use elasticity of demand data to predict
the potential impact of a price change on total sales
revenues. Price elasticity of demand affects a
business's ability to increase the price of a product.
Elastic goods are more sensitive to increases in
price, while inelastic goods are less sensitive. It
has great practical importance in the formulation of
economic policies and understanding economic
problems.
Use of Price Elasticity of demand
1.Monopoly price determination:
The elasticity of demand can make the businessmen to
increase or decrease the price for economic goods. The price
is increased when the demand is inelastic, while the price is
decreased when the demand is elastic. A monopolist while
fixing the price for his product takes into respect to its elasticity
of demand. If the demand for his product is elastic, he will profit
more by fixing a low price. In case the demand is less elastic,
he is in a position to fix a higher price.
2.Pricing of joint products:
The concept of the elasticity of demand is of much use in the pricing of joint
products,. Some times two or more than two product are produce
simultaneously in the process of production. In such cases cost of production of
each commodity can not be calculated separately because they are jointly
incurred . Therefore, the high cost is incurred for the goods which have
inelastic demand and vice versa .
For example :
Rice and husk ,the high price is fixed on the rice because its demand is
inelastic and low price is fixed on husk because its demand is elastic in this
way the price of each is fixed on the basis of its elasticity of demand.
3. Pricing of public goods :
Elasticity of demand further helps in fixing prices for the services rendered by
public utilities. Where the demand for services is inelastic, a high price is
charged; while in the case of elastic demand a low price is charged.
4. Imposition of taxation:
Price elasticity of demand is mainly of interest to the
government for the purposes of taxation. The taxation policy
depends also on the elasticity of demand because if the
finance minister imposes a tax on an economic good, first it
needs to analyze if the demand for that good is elastic or
inelastic. For example, if the demand is elastic, the finance
minister cannot raise the price of the good, but if the
demand is inelastic, the tax can be increased in order for a
larger revenue to be gathered.
5. In Wage determination:
The concept of elasticity of demand is important in the
determination of wages of a particular type of labour. If the
demand for labour in an industry is elastic, strikes and other
trade union tactics will not effect to rise wages. If, however,
the demand for labour is inelastic even the threat of a strike
by the union will induce the employers to raise the wages of
workers in industry.
6. In the determination of the gains from international
trade:
Price elasticity of demand helps to determine the terms of trade
in the international market .We will gain from international trade
if we export goods with less elasticity of demand and import
those goods for which our demand is elastic. In the first case
we will be in a position to charge a high price for our products
and in the later case we will be paying less for the goods
obtained from the other country. Thus, we gain both ways, and
shall be able to increase the volume of our exports and imports.
Income Elasticity of Demand
• Income elasticity of demand is the measure of
responsiveness of quantity demanded to the change in
income of the consumer.
• Income elasticity of demand is the define as the ratio of
percentage change in quantity demanded to the
percentage change in income of the consumer.
It can be expressed as:
Cont…………….
• Symbolically,

Where,
EY=income elasticity of demand
Q= Initial Quantity demanded
 Q= Change in quantity demand
Y= Initial income
 Y= Change in income
Types of Income elasticity

The income elasticity may be positive negative or zero


depending upon the nature of goods. The income elasticity od
demand can be divided into following three types as pointed.

 Positive income elasticity (EY>0)

 Income elasticity greater than one (EY>1)

 Income elasticity less than one (EY<1)

 Income elasticity equal to one(EY=1)

 Zero income elasticity (EY=0)

 Negative income elasticity (EY<0)


Positive Income elasticity (EY>0)

If quantity demand of a commodity increase due to


increase in income of the consumer, it is called
positive income elasticity of demand. The goods
which has positive income elasticity it is called
normal goods. It can be divided into three types.
1) Income elasticity greater than unity(EY>1)
If the percentage change in quantity demand for the
commodity is greater than the percentage change in
income of the consumer, elasticity is said to be greater
than unity.
Here, EY> 1
Positive Income elasticity (EY>0)

2) Income elasticity less than unity(E Y<1)


If the percentage change in quantity demand for the
commodity is less than the percentage change in income
of the consumer, elasticity is said to be less than unity.
Here, EY< 1

3) Income elasticity equals to unity(EY=1)


If the percentage change in quantity demand for the
commodity is equals to the percentage change in income
of the consumer, elasticity is said to be equals to unity.
Here, EY= 1
Negative Income elasticity (EY<0)

If quantity demand of a commodity decrease due


to increase in income of the consumer, it is called
negative income elasticity of demand. The goods
which has negative income elasticity it is called
inferior goods.

Zero Income elasticity (EY=0)


If quantity demand of a commodity remains
unchanged due to increase in income of the
consumer, it is called Zero income elasticity of
demand. This happens in case of neutral goods.
Note
EY Nature/types of goods
EY Nature/types of goods
EY=1 Comfort
EY>0 (Positive) Normal good EY<1 Necessary
EY>1 Luxury
EY<0 (Negative) Inferior good
EY=0 (Zero) Natural good
Measurement of income elasticity of demand

Income elasticity of demand can be measured by


three method as below.
Percentage method
Arc method
Point Method
Percentage method
In percentage method, Income elasticity of demand is
measured by dividing percentage change in quantity
demanded by percentage change in the consumer's
income. i.e.

• Symbolically,

Where,
EY=income elasticity of demand Q= Initial Quantity
demanded
 Q= Change in quantity demand Y= Initial income
 Y= Change in income
Arc Method
• If we calculate income elasticity as coefficient of
demand between two points on a demand curve
is called arc method. This method is used when
there are large change in income and quantity
demanded.
• The formula for measuring income elasticity of
demand at the middle point of the arc on the
demand curve is written as:
Arc Method

Where, Q1=Initial quantity demanded


Q2= New quantity demanded
Y1=Initial income
Y2= New income
 Q= Change in quantity demand
Y= Change in income
Point Method
In normal goods case, the slope of demand curve is
upward sloped. In point method, it measures the
proportion change in quantity demanded in respect to a
very small proportion change in income. According to
this method the income elasticity is given by

Where, Q= quantity demanded at given point


Y= income at given point
 Q= Change in quantity demand
Y= Change in income
is slop of demand curve
Point Method
Graphically, income elasticity of demand at point is
given as; In linear demand curve
Point Method
If there is nonlinear demand curve, the income
elasticity of demand at a point can be computed by
drawing tangent line to that point and using same
formula as above;
Uses of Income elasticity of demand
Some important uses of income elasticity of demand are as pointed:
1. Useful for classification of goods:
Income elasticity can be used to define the normal goods, inferior goods
or natural goods etc.
• EY Nature/types of goods
• EY>0 (Positive) Normal good
• EY=1 Comfort
• EY<1 Necessary
• EY>1 Luxury
• EY<0 (Negative)Inferior good
• EY=0 (Zero) Natural good

2. To determine the Growth opportunities of the firm


Income elasticity of demand determines the growth opportunities of the
firm .The firm whose demand function has high income elasticity will
have good growth opportunities in the expanding economy while the firm
facing low income elasticity would neither gain much nor loss .
3. Useful to forecasting demand: The concept of income elasticity of
demand can be used for forecasting demand for a product over a
period. Income elasticity helps in estimating the required production
level of commodities at certain period in future on the basis of income
level of the consumer .
3. Useful for making marketing strategy: The income elasticity is useful in
planning marketing strategy. If the firm produce the luxury items should
focused on advertising through the media that reach the high income
group people
4. Determine the effect of business cycle upon various industries : The
knowledge of income elasticity is useful in determining the effect of
business cycle on various industries..During the period of
prosperity ,income of the consumer increase and they are capable to
purchase the luxury goods then firms can sells luxury items. However
during the recession, demand for their product may decrease
rapidly .Similarly firms producing necessities goods will not benefit as
much during the period of economic prosperity
Cross elasticity of demand (EXY)
• Consumers’ demands for many products are
significantly affected by the quantities and prices of
other available products. This brings us to the
important concept called cross elasticity of
demand, which measures how much the demand
for product X is affected by a change in the price of
another good, Y.
• In other words, the cross elasticity of demand is
defined as the percentage change in the quantity
demand of one goods (X) due to percentage
change in the price of other related goods(Y)
• The cross elasticity of demand between goods X
and Y is given as:
Types of Cross elasticity of demand (EXY)
There are three types of cross elasticity of demand
as depending upon the nature of goods:
• Positive cross elasticity of demand(E XY>0)
When the quantity demanded of a commodity
increase with respect to increase in price of related
commodity or vice versa is known as positive
cross elasticity of demand. In case of substitute
goods, the cross elasticity of demand is positive.
If X and Y are substitute goods,
EXY>0
Types of Cross elasticity of demand (EXY)
• Negative cross elasticity of demand(E XY<0)
When the quantity demanded of a commodity
decrease with respect to increase in price of
related commodity or vice versa is known as
negative cross elasticity of demand. In case of
Complementary goods, the cross elasticity of
demand is negative.
If X and Y are complementary goods,
EXY<0
Types of Cross elasticity of demand (EXY)
• Zero cross elasticity of demand(E XY=0)
If quantity demand of a commodity remains
unchanged due to increase in price of other
commodity, it is called Zero cross elasticity of
demand. This happens in case of unrelated goods.
If X and Y are unrelated goods,
EXY=0
Measurement of Cross elasticity of demand (EXY)
Cross elasticity of demand can be measured by
the following two methods:
• Percentage method:
In this method, If two goods X and Y are related
goods, Cross elasticity of demand is measured
dividing percentage change in demand for good-X
by percentage change in price of good-Y
i.e.
• In symbolically

Where,
QX= Initial Quantity of –X
=Change in quantity demanded for -X
PY= Initial Price of –Y
=Change in price of -Y
Arc Method
• If we calculate cross elasticity as coefficient of
demand between two points on a demand curve
is called arc method. This method is used when
there are large change in Price of one good and
quantity demanded for others related goods.
• The formula for measuring cross elasticity of
demand at the middle point of the arc on the
demand curve is written as:
Arc Method

Where, QX1=Initial quantity demanded for-X


QX2= New quantity demanded for-X
PY1=Initial Price of -Y
PY2= New Price of -Y
 QX= Change in quantity demand for –X
(QX2-QX1)
PY= Change in Price of -Y (PY2-PY1)
Uses of cross elasticity of demand
The concept of cross elasticity is also plays vital
role in business decision making. It is important for
the producer to be aware of how the demand for
its product is likely respond to change in price of
other goods. Some uses of cross elasticity are as
pointed:
1. To classification of goods:
The cross elasticity is useful in determining the
relationship of goods in the market. Goods are classified
into substitute or complementary.
2. To classification of Industries:
The cross elasticity is useful in determining the
boundaries between industries. It means, it is useful in
order to decide to which product should include in which
industry.
3. Making pricing strategy related to other goods:
A firms may produce several related products or there
are several firms to produce complementary goods and
substitute goods. The price of one product affects the
demand for other product. The cross elasticity is also
used for making pricing strategy related to price of other
product.
4. Useful to forecasting demand:
The concept of cross elasticity of demand can be used
for forecasting demand for a product over a period. The
price of one firms affects the demand for other firm's
product The cross elasticity is also used for forecasting
the future product to produce.
5. Useful for classification of goods market.
The goods markets are classified on the basis of
elasticity of demand. If the cross elasticity of demand is
positive or very large the market is imperfect competitive
market. If cross elasticity is zero, the market structure is
monopoly. If cross elasticity is highly negative there exist
a perfect competitive market
Elasticity of supply
Elasticity of supply
• Elasticity of supply is the measure of reaction of
quantity supplied to the change in its`
determinants. A measure of responsiveness of
quantity supplied to the change in its
determinants is known as Elasticity of supply.
• Price of commodity is main determinants of
supply so, the elasticity of supply is measurement
of the degree of responsiveness of quantity
supplied to change in the price of a commodity. In
other words, Percentage change in quantity
supplied due to percentage change in its price is
said to be elasticity of supply.
Elasticity of supply
It can be expressed as:

• Symbolically,

Where,
ES=Price elasticity of supply Qs= Initial Quantity
supplied
 Qs= Change in quantity supplied P= Initial Price
Types of Elasticity of supply
Elasticity of supply is classified in to five parts as
pointed:
• Perfectly Elastic Supply (ES=∞)
• Perfectly Inelastic Supply(ES=0)
• Unitary Elastic Supply(ES=1)
• Relatively elastic Supply(ES>1)
• Relatively Inelastic Supply(ES<1)
1. Perfectly Elastic Supply
If the quantity supplied of a commodity infinitively
change due to negligible change in price of
commodity is known as perfectly elastic supply. Its
supply curve will be parallel to a horizontal straight
line given at the price. In symbolically it can be
written as:
ES=∞
2. Perfectly inelastic supply
If the quantity supplied of a commodity dose not
change with respect to change in price of
commodity is known as perfectly inelastic supply.
Its supply curve will be parallel to a vertical straight
line showing constant supply at any price. In
symbolically it can be written as:
ES=0
3. Unitary elastic Supply
If the percentage quantity supplied of a commodity
is equal to the percentage change in its price, the
supply of the commodity is known as unitary
elastic supply. It means the quantity supplied
changes proportionately to the proportionate
change in its price. Symbolically it can be express
as:
ES=1
4. Relatively elastic Supply
If the small change in price leads to large change
in quantity, then the supply is said to be relatively
elastic supply. i.e. the percentage change in
quantity supplied of a commodity is more than the
percentage change in its price, the supply of the
commodity is known as relatively elastic supply.
Symbolically it can be express as:
ES>1
5. Relatively inelastic Supply
If the large change in price leads to small change
in quantity, then the supply is said to be relatively
inelastic supply. i.e. the percentage change in
quantity supplied of a commodity is less than the
percentage change in its price, the supply of the
commodity is known as relatively inelastic supply.
Symbolically it can be express as:
ES<1
Measurement of Price elasticity of supply
There are three method of measuring the elasticity of
supply:
1. Percentage method:
In this method, Esis measure the percentage change in
the quantity supplied of a commodity with respect to
percentage change in its price.

• Symbolically,

Where,
ES=Price elasticity of supply Qs= Initial Quantity supplied
 Qs= Change in quantity suppliedP= Initial Price
2. Arc method
• If we calculate elasticity of supply as coefficient of
supply between two points on a supply curve is
called arc method. This method is used when
there are large change in price and quantity
supplied.
• The formula for measuring elasticity of supply at
the middle point of the arc on the supply curve is
written as:
2. Arc method
• In symbolically

Where,
QS1= Initial Quantity supplied QS1= New Quantity supplied
=Change in quantity Supplied
P1= Initial Price P2= new Price
=Change in price
2. Arc method
• In symbolically

Where,
QS1= Initial Quantity supplied QS1= New Quantity supplied
=Change in quantity Supplied
P1= Initial Price P2= new Price
=Change in price
3. Point method
The point method is used to measure the elasticity of
supply at a single point of the supply curve. It is
measure of the proportion change in quantity supplied
in response to a very small change in price. According
to this method the elasticity of supply is given by

Where, Qs= quantity supplied at given point


P= price at given point
 Qs= Change in quantity supplied
P= Change in price
is slop of supply curve

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